Bringing government debt under control: how painful will it be?

Last week I participated in an academics consultant meeting at the Board of Governors of the Federal Reserve to discuss the question of achieving fiscal sustainability. I have posted the note I wrote for the meeting on my web site, but here is a quick summary of some of the points I made:

1. There is no doubt that governments in advanced economies will have to go through major fiscal policy changes in the coming years to keep the debt-to-GDP ratio under control. Given current policies, debt-to-GDP ratios are likely to explode in some cases to 300 or 400% of GDP over the next decades.

2. The required changes are large. The recovery will bring deficits somehow under control but this goes nowhere in terms of achieving sustainability. Most advanced economies need to find additional revenues (or cut spending) by a large amount, somewhere in between 4 and 10 percentage points of GDP depending on the country -- and this has to happen every year for the foreseeable future (we are talking about many decades here).

3. There is no mystery to what needs to happen: governments need to increase taxes and reduce spending. Both have economic and political consequences and we need to be as smart as we can to choose changes that are efficient and have limited negative consequences on the economy (and growth).

4. Good news: We have seen large adjustments in government debt before so this adjustment is feasible. No need to go to the post-WWII decades, in the 80s and 90s we saw very large reductions in government debt in many advanced economies. We are talking about reducing the debt to GDP ratio by up to 40 percentage points in a short period of time, such as 10 years.

5. Good news (2): Some of these prior adjustments had limited consequences on growth. We normally tend to think about reductions in government spending and increases in taxes as having negative effects on growth but in several of these adjustments, growth accelerated rather than decreased (we refer to these events as "expansionary fiscal consolidations"). And when growth accelerates, this becomes a virtuous cycle as faster GDP growth reduces the debt-to-GDP ratio, generates tax revenues, etc.

6. Expansionary (growth promoting) fiscal consolidations tend to be associated to decreases in spending rather than increases in taxes and they tend to come together with a series of pro-growth reforms in other areas of the economy (Ireland post-1985 is a perfect example of this).

7. So can we hope for a nice, painless, expansionary fiscal consolidation over the next decades? Not obvious. There are several reasons why those experiences might not be easily replicated this time:

- In some countries, government spending levels have come down relative to where they were in the 80s or 90s. It is not easy to produce a significant decrease in government spending without affecting some basic services provided by the government. More so in the US where government spending is low relative to other (European) advanced economies.

- Some of the expansionary fiscal consolidations benefited from falling interest rates. As an example, Belgium reduced government debt by close to 40 percentage points in between 1996 and 2006 but most if not all of the decrease was linked to falling interest rates on government debt. Currently, there is no room for interest rates to go down. If any, they might go up.

- This time, the consolidation needs to take care of the past (the accumulated level of debt) and the future (the fact that projected deficits given current policies will be very large). The adjustment is larger than what was needed in some of those previous expansion.

8. So my guess is that a "painless" fiscal adjustment is unlikely this time. Taxes will have to play a stronger role and governments will need to strike a balance between the need for additional revenues and the potential negative growth effects that higher taxes might have. This balance will require a strong amount of political leadership and consensus.

Antonio Fatás

Health Care and Macroeconomics

Here are three charts that show the importance of the health care sector in some of the key present and future macroeconomic challenges for the US economy:

1. Health care expenditures and GDP per capita.

As a starting point, below is the correlation between per-capita expenditures on health care and GDP per capita. The US stands as an outlier. (Source: OECD)

2. Health care expenditures and imbalances prior to the current crisis. In the years prior to the crisis the US economy run large current account deficits, a sign of excess spending relative to income for the whole country. One of the components of spending that grew the fastest was private consumption. As a % of GDP it grew by about 4-5% of GDP. All of it can be accounted for by increases in health care and education as shown in the chart below (we have blogged about this before).

3. Health care and government debt. The projections for US government debt is that it will explode to a level of about 300% of GDP in the coming decades (assuming no change in policy). The biggest source of this explosion is health care costs. Yes, there are some other costs associated to aging (more need for healthcare and pension) but most of the increases in government spending comes from the assumption that health care costs will keep growing faster than GDP, as reflected in the chart below - where the units are % of GDP (Source: CBO).

So maybe health care reform was a political distraction from other issues that required the attention of US policy makers, but there is no doubt that getting health care right is a key ingredient for many of the challenges that the US will face in the years to come.

Antonio Fatás

Current account imbalances and exchange rates

The debate on the possible undervaluation of the Chinese Renminbi is in full force among politicians and academics. Most agree that the Renminbi is undervalued but there are disagreements on the effects of exchange rate misalignments (are they they ultimate cause of current account imbalances?).

Are exchange rate misalignments the main cause of current account imbalances? Here are two Nobel prize winners who disagree: Stiglitz says no and Krugman says yes. I will not resolve the debate here but there is something that I cannot understand in Krugman's argument. His argument is that current account imbalances cannot be corrected without an exchange rate change. While he does not say so, he almost implies that current account imbalances are always the result of exchange rate misalignments. This position is too extreme. The current account is the difference between national saving and investment. It is true that saving and investment will react to relative prices (which are determined by the exchange rate). But we can observe changes in saving and investment that are driven by many other factors and that have minimal impact on relative prices. Krugman's argument is that an increase in Chinese consumption will not reduce its current account surplus unless this consumption will translate into imports, and for this to happen we need a relative price change.

Krugman is right in the sense that if an increase in Chinese consumption is directed towards local goods, their price will increase, which amounts to an exchange rate appreciation. But the fundamental question is what needs to happen for the imbalance to be corrected. His view is that we first need to get prices right and then the adjustment will happen. The alternative view is that Chinese will have to get used to consume more, Americans will need to understand that they need to save more and this will be the main factor that will drive the current account adjustment. Relative prices are likely to adjust and therefore the (real) exchange rate will have to change. How much? It will all depend on how easy we can find substitutes for the goods currently produced in China. It might be that it will not take much of an increase to find an alternative location for production (with cheaper labor) and prices will change very little.

By the way, here is an interesting piece of data: while both the US and the Euro area have a large bilateral trade deficit with China (which can be interpreted as a signal of the undervaluation of the Renminbi), the Euro area has an overall current account surplus while the US has a current account deficit. You can argue that for the Euro area, an undervalued Renminbi shifts demand from other countries goods to Chinese goods. But this does not get reflected in the overall current account balance. Clearly there is more than an undervalued Renminbi in the dynamics of the current account in the US and the Euro area. And, yes, I am aware that we can argue that the Euro is undervalued relative to other currencies, as Martin Fedstein does, but then the argument becomes a tautology, every time we see a current account imbalance we conclude that it is because exchange rates are not right.

The debate has extended to the broader issue of current account imbalances and the potential blame that the countries with current account surpluses (China or Germany) have on the weakness of the economic recovery. As an example, here is Martin Wolf (FT) arguing that Germany cannot be a model for the Eurozone because of its current account surplus. Germany is accused of having kept wage growth too low and therefore forcing a "depreciation" to be more competitive. I am not sure what Martin Wolf proposes as a solution. Charles Wyplosz gets it right in his article: Germany should be running a current account surplus to save for the future and this is what many other advanced economies should be doing.

Antonio Fatás

Gross Debt, Net Debt (and future debt)

Many governments of advanced economies are struggling with large deficits and increasing debt. When the crisis is over some of these countries will find themselves with levels of government debt that we have not seen since the end of World War II and, in many cases, close to double the amount before the crisis started. Some European countries, Greece in particular, but also Portugal, Spain or Ireland are under enormous pressure to control their deficits as they see their interest rate spreads grow.

Who is in more trouble? Why is it that some of the countries that were used as models of fiscal discipline (Ireland or Spain) are now under attack? A quick look at government debt (as a % of GDP) reveals very high levels for may advanced economies. The first question is which measure of debt to use: gross or net. Gross debt is simply the stock of outstanding government debt. Net debt is the difference between gross debt and the financial assets that government holds (Note: the definition of net debt is not identical for all countries. Not all governments include the same type of financial assets).

The table below shows gross and debt levels for a group of advanced economies (this is a forecast for 2011 done by the OECD).

Government Debt as % of GDO in 2011

(source: OECD Economic Outlook)

It is clear that the difference between gross and net debt is very large for some countries. While Japan looks like an outlier in terms of gross debt, it is close to Italy and Greece when it comes to net debt. In principle, net debt is a more appropriate measure of government indebtedness. If governments have a significant amount of assets, they need to be considered when thinking about the solvency of their accounts. In some cases the government (at large) holds some of its own debt in pension funds for public employees or the social security fund (this is why in the US the most common measure of government debt is "debt held by the public" which is a measure very similar to the concept of net debt), this debt is not a liability for the government.

There are, however, some concerns with the concept of net debt. In addition to some measurement question (which assets to include, at which value), the government needs to refinance all its gross debt and not only the net part, so in terms of flows, it is the gross debt that matters. Also, while it makes sense to exclude government debt held by the government, some of this debt is part of a fund that covers future pension liabilities that are unaccounted for in the budget. And here is where the assessment of government solvency gets more difficult: what you really want to do is not just to look at government debt but also at future revenues and liabilities.

Doing these calculations requires many assumption about the future so there is always uncertainty about these assessments. Below is a chart from an article by C.Hagist, Stefan Moog, Bernd Raffelhuschen and Johannes Vatter that calculates what they call "implicit government debt" as the net present value of future liabilities minus future revenues.

The numbers are dramatic for some countries and there are are large difference between some of them. While Spain or Switzerland have levels of implicit debt that are "low", the US or the UK have levels of implicit debt that make the total debt four or five times higher than the current level of debt (total indebtedness of the UK government is 547% of GDP). This does not mean that the US and UK government are broke (or more likely to default than Switzerland). What it says is that relative to current policies, the US and the UK require larger increases in taxes or decreases in spending to stabilize their debt.

A similar analysis of the fiscal gap for the US has been done by Auerbach and Gale and they reach similar conclusions. The fiscal gap for the US government today is between 5% and 7% of GDP. Meaning that if the government wants to stabilize the debt at current levels over the next 8 decades, they need to increase taxes or cut spending by five percentage points of GDP (every year for the next eight decades). This is a very large number given that total federal tax revenues stand today at 15% of GDP (so 5 extra points amounts to a 1/3 increase in taxes!).

Given these numbers, why is it that Southern European countries are under more pressure than the US or the UK? It is all a matter of credibility and the trust in the ability of these governments to get their budget under control. It might be that the UK needs a larger effort than Ireland but the question is which one is more likely to deliver on this effort. And the moment credibility is low, interest rate spreads increase and the fiscal gap increases as well as you need to generate more revenues to simply cover the interest payment on the debt.

Credibility will always be a subjective assessment and it is always easy to argue that markets are getting it wrong (or right) for a given country. What is important is to understand the numbers, not just the current ones but the future ones as well, before making that assessment, otherwise we are only seeing the tip of the iceberg and ignoring the true size of the problem.

Antonio Fatás

The apparent weakness of the Euro (please define "weak")

In today's Financial Times, Wolfgang Munchau writes about "Why the Euro will continue to weaken". He makes an argument that we have heard before: the political tensions, the economic tensions created by the Greek debt problem make it clear that a monetary union without a political union cannot be successful.

I will ignore the general question on whether a monetary union can succeed without a political union so that I keep this entry short, but I want to challenge his reading of exchange rates.

Let me start with the areas where I agree with the FT article: Is the Euro getting weaker? Yes, relative to the US dollar. Is this caused by the perception that some of the economic troubles in Greece and other European countries could cause instability in the Euro area? Yes.

Here is where I disagree: Is the Euro a weak currency? To be honest, I cannot answer this question unless we agree on a definition of "weak". If by "weak" we mean that its current value is low relative to some benchmark (and we also need to agree to a benchmark), the answer is NO. The Euro remains overvalued according to purchasing power parity (PPP), which is the most fundamental theory we have about exchange rates (I am aware that there are more sophisticated models to think about over/undervaluation of currencies but at some point they need to rely on some notion of purchasing power parity as a long-term anchor).

The current value of the Euro (about 1.36 USD/EUR) is higher than what most PPP estimates indicate. Those tend to be in the range 1-1.2, depending on the basket of goods that you use. If any, the Euro remains overvalued. We reach a similar conclusion is we look at the historical evolution of the USD/EUR exchange rate (see chart below) where the German Mark is being used as the Euro in the pre-1999 period.

My second disagreement with the article is about the connection between political and economic turmoil and exchange rates. Why should the current European environment lead to a depreciation of the currency? The informal argument is that the currency reflects the "strength" of an economy. This sounds ok but it is not right - you first need to define "strength" and then be clear about the exact economic mechanisms through which the exchange rate is affected. Wolfgang Munchau argues that Europe needs to go through a major fiscal adjustment and this implies an increase in public saving. Given that the sum of public and private (net) saving have to be equal to the current account, and assuming that we do not want private saving to fall, we need to see the current account going up (exports growing faster than imports). For this to happen, you need to see a depreciating Euro. This logic is not right either. If we apply the same logic to the US or the UK we will reach the same conclusion: we need a depreciating US dollar and a depreciating UK Pound. But this is impossible! We cannot have the three currencies depreciating at the same time (at least relative to each other).

The argument that the political tensions in the Euro area will lead to a weaker Euro are not new. They were in fashion during the early years of the Euro when the Euro was getting weaker (as low as 0.85 USD/EUR). Funny enough, those theories became irrelevant in the period 2003-2007 when the Euro appreciated by close to 100% relative to the dollar. And this was at the time when the political and institutional weaknesses of the Euro area became really apparent. It was during the 2003-07 period when the stability and growth pact collapsed, it was during that period when several countries did not live by the deficit and debt limits that they had agreed to and the confidence in the Euro-institutions was seriously damaged. But during those years the Euro got stronger, not weaker.

Theories about why exchange rates move need to be tested over several episodes. Otherwise we are simply looking for an ex-post rationalization of the changes we see.

Antonio Fatás

Greek debt woes will remain (CNBC interview with Ilian)

Maybe the Euro was not such a bad idea.

The current budgetary crisis in Greece has led to concerns about the stability of the Euro zone as a single currency area. There have been talks about the possibility of some countries leaving the Euro area and some see this as a clear signal that having a single currency among such a diverse group of countries was a bad idea. A few academics in the US have reopened the debate on whether the Euro zone is indeed “an optimal currency area” and their conclusion tends to be that it is not and the crisis with Greece is a proof of that analysis.

Their logic of those who believe that the Euro was a bad idea is the following: if today countries such as Spain, Greece or Portugal (or Italy) had their currency, they could have devalued it (or depreciated it) and this would have helped them to get out of the crisis because of the positive effect on exports. They point out to the fact that in recent years some of these countries have lost competitiveness through high inflation and this could be easily corrected with a devaluation while the alternative of deflation (or lower inflation) is more painful.

Their argument is a standard textbook analysis of the costs and benefits of keeping your own currency (where we are looking at just the benefits). This is an argument that I bring up regularly in class when I teach macroeconomics and it is easy to explain to my students. However, one needs to go beyond the theory and what is difficult is to assess whether the logic applies to this case and indeed these benefits outweigh the costs of having your own currency and exchange rate.

My reading of the current situation is that it does not reflect at all on the weaknesses of the Euro zone as a currency area and that if any of those countries had kept their currencies they would be in much more trouble today.

Here is a long list of arguments of why the textbook argument does not apply to this case:

1. This is a global crisis. The current recession is global in nature. While some countries are hurting more than others, this is not an asymmetric shock that is affecting just one country. While the exports of Greece could benefit from devaluation, this would hurt the exports of other countries. While it is true that some countries like Germany have kept a surplus in their current account, it is also true that their exports have collapsed and their GDP has been affected as much or even more than some of those other countries. Why shouldn’t be Germany the one who devalues?

2. Is competitiveness a problem? A potential answer to the question in point #1 above is that Germany does not have the same problems of competitiveness than the Southern European countries. It is Spain, Portugal, Greece the countries that have seen their real exchange rate appreciating because of higher inflation than in Germany. They are the ones that need the correction. This is true but we have to be careful not to use Germany as an example of all other countries. The chart below (from a presentation by Jose Manuel Campa, from the Ministry of Economy and Finance in Spain), Spain has not seen a deterioration of competitiveness relative to France, the second largest economy in the Euro area. It is Germany the one that looks like an outlier.

In addition, inflation was higher in Spain mainly because of the evolution of prices in the non-tradable sector (the one where competitiveness is not an issue). Below is another picture from the same presentation by Jose Manuel Campa where we see that the evolution of unit labor cost in manufacturing in Spain (relative to Germany) are much more moderate.

If this is not reassuring enough we can look at the evolution of Spanish exports (as a share of world exports) during these years, Spain has done better than countries like France or the US and its performance is similar to that of Germany.

Yes, Spain had a large current account deficit during these years but it was mainly the result of increasing imports due to the strong expansion in the economy. A phenomenon that we observed in other countries (such as the US) that have a flexible exchange rate.

3. Exchange rates are not a magical tool. If having your own currency is such a powerful tool to deal with crisis like the current one, why is it that countries such as the UK, Sweden or the US are suffering through very deep recessions? Both the UK and Sweden, despite having witnessed a depreciation of their currencies, are also struggling with a deep recession that seems to be lasting as long as in some of the Euro countries. In the case of the US, the currency has moved in the “opposite” direction and appreciated since the beginning of the crisis. The current account has been reduced but mainly because of the collapse in demand that comes from the recession.

4. We cannot forget the costs of having your own currency. While the idea of manipulating the exchange rate to increase exports might seem at times attractive, there is no doubt that if any of the Southern European countries had their own currency today, they would be in a much deeper recession (we can go back to the early 80s in Spain when there was also a banking crisis to see how much the Spanish peseta helped). It would be very likely that these countries had accumulated during the boom years liabilities in foreign currency that now, with a devaluation, they would not be able to pay back. The government of Greece would be facing a much higher interest rate because of exchange rate risk, which would make the probability of default even higher.

Finally, a reminder that one needs a longer perspective to assess the benefits and costs of a monetary union. Yes, countries like Spain are going through a deep recession with very high unemployment rate but partly this is the result of the “excesses” of the previous years. Below is a picture of real GDP that shows the very-high growth rates that Spain enjoyed during the previous years. While it might be the case that there was some loss of competitiveness relative to Germany, the growth rate of Spain remained very high, higher than that of Germany or the UK who had the flexible exchange rate to adjust (if needed). Yes, the current recession will erase some of these gains, but not all of them.

So maybe the Euro was not such a bad idea after all and it deserved a less dramatic 10^th anniversary.

Antonio Fatás